Market Comment March 2021- Taking the buzz out of the story What is the reflation story all about?
The financial markets seem intent on changing the buzzwords of 2020 — the virus, virtual, work from home, recession — into vaccines, the real world, back to the office and reflation. Reflation is the current euphemism for inflation which spooked the markets in the past two weeks leading to higher yields on government bonds and a correction of the pandemic induced high valuations of the tech stocks. Are we headed for the much-touted sector rotation – into real economy stocks and out of tch stocks – or is the market barking up the wrong tree?
The reality is that while inflation will spike in the second quarter, it is not likely to last, not likely to concern consumers, and not likely to change central bank policy.
Inflation erodes the value of the interest payments on bonds, and dents the debt’s value, so the current worry of higher rates tipped global government bond markets into their weakest start to a year since 2015. The yield on the benchmark 10-year US Treasury breached 1.4 %, having started the year at about 0.9 per cent. Yields rise when prices fall.
Yields remain low by historical standards. But the fact they have been so low over the past year has provided a key support for stocks, which have rushed higher over the past eleven months. When investors believe that yields pick up, particularly real yields that are adjusted for inflation, they fret that some of the frothier corners of the stock markets are left vulnerable.
The dramatic interest rate move reflects expectations of a robust economic recovery. We have never gone from locking down an economy to opening it back up with this amount of stimulus. The consensus prediction for global GDP growth in 2021 is just over 5%. Some estimates see growth topping 6% worldwide and reach 8% in the US. Estimates of the combined central bank and government stimulus measures already totaled USD 20tn last year, or more than a fifth of global economic output. These numbers do not include the additional USD 1.9tn spending package being readied by President Joe Biden’s administration.
The risk of an overheating economy with signs of higher inflation would call central banks to action. The Fed announced last Summer that its inflation target will be an average of 2% - it did not specify over what time frame – and would only consider acting in interest rates once the economy reaches full-employment. The latter criteria will prove harder to achieve in the next few years.
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We still see powerful disinflationary trends. After an initial recovery from the pandemic there is likely to be a world of excess capacity when we re-start moth-balled production lines and re-open hotels and restaurants. Inflation will remain contained because of long-established trends such as technological innovation that lead to cutting costs – i.e. digitization - and the slack in the labor market due to persistent high unemployment.
Any inflation pick-up will prove temporary. The current sector rotation out of tech stocks into stocks of the real economy will also prove temporary. Blue-chip stocks have some catching-up to do but beware of zombie corporations being held up by cheap credit and government support. The trends that Corona accelerated will continue to matter and will still be great places to invest. Virtual and work-from-home and their related themes are still strong buzzwords for 2021.
Switzerland, March 1st, 2021